Investors should enjoy the love for mergers

As you may have noticed, corporations have had the urge to merge lately. Some are achin’ to be taken abroad for tax benefits; others just want to get married, settle down and crush the competition.

Whatever the reason, companies are taking each other over at a frenetic pace. Is there any way that you, as an investor, can take advantage of this? Certainly. But it’s probably not by figuring out the next big takeover target.

Thomson Reuters figures that global merger activity has hit $2.2 trillion this year, up from $1.29 trillion during the same period in 2013, and the most since 2007. Just this year, Comcast announced it is buying Time Warner Cable for $45 billion; Reynolds American is inhaling Lorillard for $27 billion; and Medtronic is moving to Ireland for a wee bit o’ tax avoidin’ with a $43 billion purchase of Covidien.

What’s driving corporate matrimony? Nonfinancial companies in the Standard and Poor’s 500 have a near-record $1.2 trillion in cash sitting on their balance sheets, which, thanks to low interest rates and mild inflation, is melting like an ice sculpture at a Cancun beach wedding. Financing an acquisition is cheap these days, and some CEOs may be wondering just how long these days of cheap financing will continue.

But confidence in the economy and the markets may be the key. “Conditions for an increase in M&A activity have been in place for a while,” said Chis Lee, manager of Fidelity Select Financial Services Portfolio. “Part of the constraint was around confidence at the CEO or the board level. Now, the risk of doing nothing seems greater than the risk of doing something.”

More confident

Now that companies feel more confident, they’re making the decision that it’s cheaper to buy a rival than to build out their own expansion. In other cases, companies may get a lighter tax treatment by merging with a foreign competitor – although they also run the risk of facing the wrath of Congress and the public, as Walgreens discovered recently.

Mergers are not always good things: Many times, companies just aren’t good matches. America Online and Time Warner, for example, tied the knot in 2000 for $164 billion, then divorced in 2009, when Time Warner sent AOL packing.

But mergers can be very good for the shareholders of the companies that are purchased, in large part because the buyer nearly always overpays. Typically, when a merger is announced, shares of the target company rise, while shares of the purchasing company fall. (One sign of the strength of the M&A market recently has been that shares of both companies have tended to rise on the announcement, which is fairly unusual.)

One classic way to profit from mergers is called merger arbitrage. When two companies announce a merger, you buy shares of the company that’s being acquired. At the same time, you sell short the shares of the company that’s doing the buying. (A short sale is a bet that shares will fall.)

This is a conservative strategy, meant to produce small gains with low volatility – more like a bond fund than a stock fund. The Merger Investor Fund, for example, has averaged a 3.43 percent average annual gain the past five years. In 2008, when the Standard & Poor’s 500-stock index fell 37 percent, Merger investor fell 2.3 percent. Another, similar fund is the Arbitrage fund, which has averaged a 2.06 percent gain the past five years.

Aggressive approach

Gabelli Mergers and Acquisitions takes a more aggressive approach and tries to spot M&A targets as well as using arbitrage. It’s a riskier fund than the pure arbitrage funds, but it’s up an average 7.4 percent a year the past five years, according to Morningstar.

The best money in M&A, however, is probably through investing in the companies that arrange the deals. “One segment that will do well is the M&A advisers,” said Peter Kovalski, manager of Alpine Financial Services fund. Two of his favorites: Evercore Partners and Greenhill & Co.

Another play on the M&A boom would be the big banks, most of which have large divisions that help advise mergers and get financing for them. The problem with the big banks, of course, is that many still are paying their debt to society for misdeeds in the runup to the 2007-2008 financial crisis.

“They’re still easy pickings for attorneys general who are trying to establish their careers,” Kovalski said. He thinks the big banks will do well in the long term, but that there could be more ugly litigation settlements in the next six months.

Finally, for the most diversified M&A play, consider a value fund. These funds typically look for stocks that Wall Street has thrown out the window and left for dead. They don’t look for merger targets, but the stocks they favor tend to be so cheap that a merger might be the best thing to happen to them. Some favorites: Dodge & Cox Stock, Vanguard Windsor and Hotchkis & Wiley Value Opportunities.

The problem with M&A booms is that they rarely end well. Fidelity’s Lee thinks that U.S. M&A levels are about near normal, while global M&A, especially in Europe, is below normal levels. “Traditionally, deals beget deals,” he said. For the moment, despite the large increase in deals, the M&A boom seems at reasonable levels. But if you commit to an M&A strategy, make sure you keep one eye on the exits.